Today's release of March federal budget numbers was mixed. Three broad themes remain in place: 1) annual outlays have grown very little since the recovery started (only $90 billion), thanks to Congressional gridlock; 2) revenue growth has slowed over the past year, thanks to the payroll tax cut and only moderate growth in jobs; and 3) the budget deficit continues to decline relative to GDP (from a high of 10.4% in late '09 to 8% now), thanks mainly to increased tax revenues and stagnant spending. If Congress can continue to hold the line on spending, and if the economy continues to grow, the budget deficit will slowly fade away as a pressing problem—but of course this could take many years.
I can't resist posting an updated version of this chart, even though every time I do, it creates a storm of controversy. Students of the business cycle know that a recession typically leads to increased spending (e.g., automatic stabilizers such as unemployment benefits and food stamps kick in), so it is natural for spending to increase relative to GDP (blue line in the above chart), at the same time that the unemployment rate increases (red line). Similarly, recoveries reduce unemployment and that takes some pressure off of spending. But the most recent recession was an outlier, since it featured a surge in spending the likes of which we haven't seen since WW II. This time around, spending wasn't just driven by an increase in unemployment benefits and automatic stabilizers, it was also driven by Washington's attempt to seriously boost spending on things that were supposed to strengthen the economy. But as we now know, a trillion dollars of "stimulus" spending failed to boost the economy and failed to bring down the unemployment rate as its proponents had argued.
My point here (which is difficult to prove, I know) is that "stimulus" spending actually ended up weakening the economy, and that is why the level of spending relative to GDP is still very high and the unemployment rate is still very high. When the government redirects a significant amount of the economy's resources in the name of "stimulus," what it is actually doing is hobbling the economy by taking money from those who are more productive and giving it to those who are less productive. Transfer payments have surged, unemployment benefits have been extended in unprecedented fashion, and "stimulus" funds have been wasted on "make-work" projects. None of this helps create jobs, and in fact the incentives for new job creation have only declined, due to increased regulatory burdens and the fear that huge increases in future tax burdens will be required to reduce the bulging federal debt.
The implication here is that since deficit-financed spending increases can weaken an economy, reductions in spending relative to GDP can strengthen an economy. We're on that virtuous path to some extent, and that is why the unemployment rate is slowly declining. But it would be far better if we—and the Europeans—could make a more vigorous effort to reduce spending relative to GDP. That's the kind of "austerity" that leads to a stronger economy.
UPDATE: It occurs to me that there is another reason for why the huge increase in spending vs. GDP in recent years has corresponded so tightly to the unemployment rate. The unprecedented expansion of unemployment benefits and the equally unprecedented increase in food stamp benefits in recent years has undoubtedly played a role in reducing the labor force participation rate (many people may have decided to stop seeking employment in order to enjoy extended/emergency unemployment benefits and food stamps), and the reduction in size and lack of growth in recent years of the labor force has been an important contributor to the decline in the unemployment rate. I don't have facts or figures to back this up, but it does seem intuitive.